Just when investors started doubting the safe-haven status of gold at the time of the sub-prime mortgage debacle putting pressure on most financial markets, the yellow metal came to life and staged a spectacular $56 rally. Although not expecting anything as dramatic, I have for a while been advocating a strong emphasis on gold (see posting “Gold – more than a safe-haven play”, August 14, 2007).

The last week’s move has taken the gold price to above $700 for the first time in more than 16 months. It has also taken gold to within $143 of its all-time high of $850 reached on January 21, 1980 and within $23 of its May 12, 2006 high of $730 (which, incidentally, was the highest level since 1981).

The surge in the gold price also saw the StreetTracks Gold Trust (GLD), the bullion-backed ETF, adding an additional 51 metric tonnes of gold since September 4, for a total of 567 tonnes on deposit. This equates to a market value of $12.9 billion.

As they say, a picture tells a thousand words …

Source: StockCharts.com

The chart pattern for gold has been a classic one of mapping out consistently higher lows, and this positive trend is now being confirmed day by day by an increasingly bullish fundamental landscape, especially in the light of central banks now running the printing presses and pursuing an “inflate or die” monetary policy. Not to mention a rampant oil price that has just reached an all-time high.

The tanking US dollar has been hugely beneficial for the rising gold price as can be seen from the graph below showing the good inverse relationship between the US dollar and the gold price. And with the near certainty of Fed funds rate cuts commencing next week, the interest rate differential between the US and other major economies is set to decrease. It will therefore not come as a surprise if the US Dollar Index challenges its 1992 all-time low of 78.19 before too long, i.e. sustaining a favorable headwind for the gold price.

Source: StockCharts.com

However, the gold price has not only strengthened in US dollar terms, but has in fact been appreciating in most major (and minor) currencies. This uncoupling from currencies is typically a sign of strong investor demand being present, i.e. the so-called second phase of a typical gold bull market cycle – see posting “Gold bullion: avoid or accumulate“, June 11, 2007).

GOLD PRICE MOVEMENTS IN VARIOUS CURRENCIES

Gold price in various currencies

2005

2006

2007 (YTD: Sept 12, 2007)

Gold in US dollar

17.9%

23.1%

11.8%

Gold in euro

34.9%

10.5%

6.1%

Gold in British pound

31.3%

8.3%

7.9%

Gold in Swiss franc

35.9%

14.1%

8.6%

Gold in yen

35.5%

24.4%

7.2%

Gold in Aus dollar

24.9%

13.9%

5.7%

Gold in Can dollar

14.0%

23.5%

-0.5%

Gold in rand

31.9%

37.1%

13.5%

Gold in renminbi

15.0%

19.1%

7.7%

Gold in rupee

22.7%

20.8%

2.1%

Gold in dinar

17.9%

23.2%

8.5%

Source: Plexus Asset Management (based on data from I-Net)

Investor demand has been coming from a number of governments increasingly diversifying out of US dollars and into gold. The Chinese government, having eased restrictions, is for all intents and purposes encouraging its citizens to buy gold. According to the World Gold Council, China’s demand for gold increased by nearly one-third during the second quarter of 2007, and early indications from India are for a “very, very strong” year.

It is also of interest that a gold-backed ETF is being planned for listing on the Tokyo Stock Exchange during the spring of 2008. A yen-denominated ETF tracking the gold price has also just been listed on the Osaka Securities Exchange, but this is not backed by bullion.

And then there is the Comex gold contracts story mentioned in my posting “Smart money bets on surging gold price” (September 4, 2007). The article referred to a research study by Adrian Douglas (www.marketforceanalysis.com) dealing with an analysis of the open interest of Comex gold options. Douglas’s track record on this front is excellent as he predicted in November 2005, when the gold price was less than $460, that a mega-move was afoot.

Douglas based his forecast on a very large build-up of call options in the underlying stocks of the AMEX Gold Bugs (HUI) Index. This turned out to be spot-on as gold subsequently surged to $730 by May 2006. Similar to 2005, Douglas has now again noticed a massive build-up of call options in the October and December Comex gold contracts.

While we are on the topic of the HUI Index, it is opportune to also consider the recent performance of gold stocks compared with the gold price. The chart below shows how gold stocks have been trending sideways since April 2006. Although the stocks are still locked into a horizontal trading band, the HUI Index has been outperforming the gold price since August 17 (i.e. the date of the Fed’s cut of the discount rate) (see middle portion).

Source: Market Master

The bottom portion of the diagram shows the MACD oscillator of the HUI Index relative to the gold price. This seems to be firmly in bullish territory – a good indicator of gold stocks propelling the bullion price higher.

At this stage I would be inclined to have about 66% exposure to the yellow metal with the balance invested in a basket of gold stocks such as the Merrill Lynch Gold and General Fund. Any pull-back in gold stocks, from what is possibly a short-term overbought situation, can be used to adjust the weightings to equal proportions.

The fundamental and technical gold story looks decidedly positive. Any short-term correction should therefore be viewed as a buying opportunity. This may come in the form of investors once again becoming preoccupied with raising liquidity as seen in July, but don’t let that scare you off – stay focused on the glitter.

3 comments to Gold: forwards and upwards

You make a lot of assertions for higher gold prices most of which are unproven and/or statistically insignificant. For example, you mention gold as a safe haven from equities. I would agree with this as supported by propietray data that measures when the stock market is a buy or sell; however, I would ask how are you measuring when equities are at risk? With measures of investor sentiment so bearish, the market is a better buy than sell. (This is based upon 18 years of data and numerous data points as opposed to one data point during a bull market). Another example is your statement that CB’s are lowering rates and/ or increasing liquidity. While I don’t disagree with the theme, it is the level of interest rates relative to the rate of inflation that is the key here. Direction of short term yields do not predict prices of gold. Short term yields are already low and have preceded the action by the Fed for months now. I ask: why didn’t gold “pop” before this especially since stocks moved higher on Aug 17 in response to increasing liquidity. Lastly, the movements of gold and the dollar are poorly correlated.

The thing to look at in my opinion will be the rate of inflation as measured by y-o-y change in CPI; this is likely to increase come Nov and Dec. and Jan. It will be hard for the Fed to decrease rates less than 0.5% with headline inflation greater than 4%. If they do, than gold will surge. But in my opinion (for now) with short term yields above the rate of inflation and the “safe haven” status a misnomer for now (as stocks are a better buy than gold), gold’s upside should remain capped.

Gold’s breakout has yet to be confirmed by like movements in silver, copper, platinum, or paladium. Until some such confirmation is present, I would suspect this breakout to be subject to a quick, downside reversal. I don’t see much in upside prospect past 750.